Bailing Out Homeowners Isn't Easy

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The Obama administration is unhappy with the slow pace of mortgage bailouts that banks and other lenders are crafting under the government's Making Homes Affordable plan. And so administration officials gathered financial executives in Washington to "knock heads" a bit, or to "encourage" lenders to move faster, depending on which news account of the meeting you believe.

Critics are unhappy with the banks for not staffing up fast enough to administer the program, which relies on government subsidies to help homeowners lower their mortgage payments to 31 percent of monthly income. Borrowers who've tried to sign onto the program report long waits to get a response from their banks, which have prompted members of Congress and consumer advocates to accuse the banks of not being public spirited enough.

Yet there is little mystery why modifications are moving so slowly. Rewriting mortgages that must first be identified as "potentially troubled" is not a pro forma business that can be so easily reduced to a formula that a software program performs, especially in the multi-layered Making Homes Affordable plan, which operates under a series of criteria that borrowers must meet to qualify. And so, even big lenders that were churning out boatloads of loans during the housing boom are taking each potential loan modification on a case-by-case basis, and have completed relatively few of them to date.

In the long debate about proposed housing bailout plans, many proponents never acknowledged that their chief shortcoming would be the massive resources they would require. The Obama administration's Making Homes Affordable was characteristic of the many different plans proposed in that it attempts to weed out the undeserving borrower by creating a set of conditions that homeowners need to measure up to, then relies on the banks to devote the means to sift through mortgages, find those that are salvageable, and finally rewrite enough of them to have a significant impact on the economy. For this to work, the Obama plan pays a bank $1,000 for each loan it rewrites that stays current.

One reason proponents promoted this plan is because, they argued, the federal government had done it all before, during the Great Depression, with the massive Home Owners' Loan Corp., and therefore could do it again. If anything, critics of the current lender-led bailout effort say, the administration should go further now by taking the mortgage bailout plan away from banks and putting it in-house via a new federalized bureaucracy like HOLC. But in fact, HOLC was far from the whopping success that enthusiasts claim it was, and its struggles illustrate the problems that today's bailout plan will face.

The feds created HOLC with legislation designed to stop the Great Depression's housing crisis, which reached a peak with 1,000 homes a day going into foreclosure, on average, by early 1933. What emerged was a massive new federal agency to rewrite what would eventually be 1 million mortgages after first buying them up from banks with the proceeds from tax-free bonds. To do this the government hired some 20,000 people, including appraisers, loan officers, and auditors. At HOLC's peak in 1936 the bailout agency's annual payroll reached $26 million, the equivalent of about $390 million today.

If you think Obama officials are impatient with the pace of its bailout program three months after it got underway, consider that HOLC had remade only 50,000 mortgages nine months after it had been created and didn't hit its lending stride until June of 1934. That might sound impressive considering HOLC was started from scratch, but it is also a symptom of the larger problem with bailout programs, that they take so long to get going they frequently address a problem long after the crisis has emerged.

But HOLC had bigger problems. We have awfully good data on its efforts (those 20,000 employees kept nice records), which shows that 20 percent of all the new, cheaper mortgages made by the agency failed again, a whopping foreclosure rate. Even worse, many of the new, cheaper mortgages went bad because homeowners walked away from them after living free off the government.

An analysis of HOLC's records by Columbia University economist Lloyd Harriss in 1951 classified about 65 percent of the foreclosures as either resulting from "non-cooperation" of borrowers (who simply refused to pay or refused HOLC's advice on how to improve their economic situation so they could pay), or from "obstinate refusal" of borrowers who could afford to repay, based on HOLC's own appraisal of borrowers' circumstances, but simply refused to. As word spread that HOLC would only reluctantly toss people out of their homes because public opinion had been rising against foreclosures, some borrowers simply decided to live rent-free at the government's expense.

"This type of noncooperation could sometimes be attributed to a desire to obtain free housing . . . an object that, in view of HOLC's nature, was not difficult to realize," Harriss wrote.

Despite this questionable record, HOLC is typically held up as a paragon of government bailouts because it officially recorded a profit, or surplus, before it was eventually liquidated after World War II. Imagine that: a bailout program and a profit. But this is just nonsense, a fiction of creative accounting.

HOLC was not required to account for the cost of the $200 million capital advance it received courtesy of the taxpayers, didn't have to pay state and local taxes (including real estate taxes), got free use of the U.S. mail (a $6 million savings) and didn't have to pay Social Security taxes. Its modest surplus was actually somewhere between a $50 million and $100 million loss (maybe $500 million to $1 billion in today's terms). That might seem like a bargain considering the cost of some federal programs these days, until one pauses to remember that HOLC took so long to set up it made most of its loans well after the foreclosure crisis had peaked. And there's little evidence its purchase of bad loans ever spurred a lending revival. Total mortgage lending stayed absolutely flat for the rest of the decade.

In attempting to prompt the banks to move faster on its own bailout program, the Obama administration is encountering some of the same challenges faced by HOLC 75 years ago. An analysis of current foreclosure patterns by Professor Stan Liebowitz, director of the Center for the Analysis of Property Rights and Innovation at the University of Texas, Dallas, found that high interest rates or high income-to-payment ratios are not driving foreclosures. Rather, homeowners who are "underwater," that is, whose homes are worth less than the balance on their mortgage, are most likely to default. Many of these homeowners are apparently walking away from their homes right now because they put little money down and have little to lose by absconding, especially in so-called no recourse states, where a lender can't pursue your other assets if you default on a mortgage.

If Liebowitz is right, then reworking income-to-payment ratios will have little impact on default rates but may at most provide some buyers with a temporary government living subsidy as they wait to see whether the housing market turns up swiftly enough to make their investment start looking good again. If not, we're likely to see a whole new round of defaults several years out enabled by the Making Homes Affordable, and this time the taxpayer will be on the hook, not banks.

Prof. Liebowitz' data suggest that many of those losing their homes were not saddled with mortgages they didn't understand but were clear-eyed buyers who are now making a rational economic choice to default as a way of dumping a bad investment, just as those who refused to pay HOLC back in the 1930s but lived for free as long as they could were making the same kind of rational choice. People can sense when they have a sucker on the line, especially when it's the government.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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